Insight Center: Publications

Bonus Accrual and the 2½ Month Rule: New CCA Shines Light on IRS Position

Tax Update

Authors: Todd B. Reinstein and Ellen McElroy


It is common industry practice for corporate taxpayers to accrue employee bonuses earned throughout the year with the anticipation that they will be paid within 2 ½ months from the end of the year. Under Section 404,1 although deferred compensation payments may be otherwise deductible, (i.e., a company has accrued the amount and satisfied the all events test), these payments are not deductible until the employee has reported the compensation in income. Thus, Section 404 generally requires a matching of deferred compensation income and expense. As a result, deferred compensation payment deductions are generally deferred to a year subsequent to the year of payment. However, immediate deduction is available in certain circumstances – that is, if the deferred compensation payment satisfies the requirements of Sections 404 and 451. If the payment is made within 2 ½ months of the end of the employer’s tax year in which the services creating the right to the compensation are performed, then the compensation payments are deducted in the tax year in which the services were performed (known as the "2 ½ month rule.").2 Under the 2 ½ month rule, companies must meet the following conditions: (i) the accrual meets the "all events test" and (ii) it pays the bonus within 2 ½ months after year-end.

To meet the all events test, the liability must be determined with reasonable accuracy and economic performance must have occurred with respect to the liability. Most companies feel they meet the all events test for employees that have met the bonus plan’s goals during the year and by virtue of declaring the amount of the bonus before the year-end. Caution is advised, however, because this may not be as simple as it looks. A recent Chief Counsel Advice memorandum (CCA) points out that other variables may preclude the liability from meeting the all events test.

CCA 200949040

On December 4, 2009, the IRS issued CCA 200949040 denying the taxpayer’s accounting method change to deduct a bonus in the year accrued as opposed to the following year when the bonus was paid. As described in the CCA, the taxpayer’s incentive plan required that employees could only receive the bonuses if they were employed by the taxpayer on the date the bonuses were paid in the following tax year. Unpaid bonuses were supposed to revert back to the corporation and be paid to a charity.3 In this CCA, the IRS concluded that the taxpayer’s requirements regarding bonus reversions created a contingency, and as such, the liability to pay the bonuses could not be considered fixed until the contingency was satisfied. Consequently, the IRS concludes that no deduction would be available until the contingency was removed (i.e., if the individual was employed on the date the bonus was paid).

By way of background, the taxpayer sought to treat the bonuses paid within 2 ½ months of the following year as properly accrued and deductible in the previous tax year under an accounting method change. The IRS concluded that the taxpayer’s liability arising from the incentive plan must be taken into account in the year paid and not the year accrued since the payment was contingent on the taxpayer’s employees still being employed in order to receive the bonuses. The taxpayer in the CCA argued that it had a fixed and determinable liability at the end of the first year for 90 percent of the amount accrued for financial statement purposes for its incentive plans for the first year, and thus, was entitled to take it as a deduction in the first year.

The IRS disagreed and explained that the taxpayer’s failure to contribute funds to charity did not mean that the taxpayer necessarily satisfied the requirements of the all events test. The IRS focused on the fact that the liability was not fixed in the first year because the employees had to perform services in the second year and be employed by the taxpayer when the bonuses were paid. According to the IRS, this meant that the taxpayer did not know at the end of the first year whether it owed bonuses to any employee. Also, there was no indication that the corporation’s employees (or ex-employees) could require the corporation to make a charitable contribution absent the bonus payments.

Pepper Perspective

Taxpayers looking at preparing their year-end provision should carefully review their incentive compensation plan requirements before taking the benefit of their bonus accrual. If they do not meet the criteria set forth in the CCA, they may want to consider avenues to mitigate any potential exposure. Publication of the CCA would indicate that IRS Exam teams will closely scrutinize the treatment of these items. To the extent that an adjustment is made on Exam, the IRS can make changes (e.g., defer the year in which the deductions are taken) in the earliest open year. Any Exam adjustments will be taken into account immediately. One way to mitigate any exposure is to file a change in accounting method. This method change is available automatically and it may be filed with the annual tax return. Such a change provides audit protection and any unfavorable Section 481(a) adjustment would be recognized over four years rather than immediately, as would occur in an Exam adjustment. Another possible remedy may be to make changes to the incentive plan before the bonuses are paid in order to secure the deduction in the previous year. To ensure that other changes are not made in an earlier year by IRS Exam, it also may be prudent to consider changes to earlier-filed returns through an amended return.


1 Unless otherwise stated, all references to "Section" are to the Internal Revenue Code of 1986, as amended, and all references to the "Regulations" or to "Treas. Reg." are to the Treasury Regulations promulgated thereunder.

2 See Treas. Reg. Section 1.404(b)-1T(b)(1), which describes the 2 ½ month rule.

3 Note: The CCA points out that the taxpayer did not make any charitable contributions in this way.

Todd B. Reinstein and Ellen McElroy

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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